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Oct. 3 (Bloomberg) -- European government bonds rose for a second week after central bank President Jean-Claude Trichet indicated policy makers may cut interest rates this year to counter a weakening economy.

Gains sent two-year yields to the lowest level in more than six months as a report showed retail sales in the euro region fell in August. Trichet said yesterday the European Central Bank discussed a reduction in borrowing costs. It kept the main refinancing rate at 4.25 percent, as forecast by economists surveyed by Bloomberg. Bonds pared gains as stocks rebounded from earlier losses on speculation U.S. lawmakers will approve a $700 billion bank-rescue plan.

``It would appear a rate cut by the end of December is a great possibility,'' said Marc Ostwald, a fixed-income strategist in London at Monument Securities Ltd. ``Bonds are also watching equities, and the flight-to-safety bid can be sustained.''

The yield on the two-year note was at 3.31 percent by 5:07 p.m. in London, taking its decline this week to 35 basis points. The price of the 4 percent note due September 2010 dropped 0.03, or 30 euro cents per 1,000-euro ($1,385) face amount, to 101.26.

The yield on the German 10-year bund, Europe's benchmark government security, slipped 1 basis point to 3.92 percent, leaving it 25 basis points lower since Sept. 26. Yields move inversely to bond prices.

Thirty-year bonds surged by the most since the euro was introduced in 1999 on speculation that pension funds in the Netherlands are buying the securities to boost their balance sheets. The yield on a 30-year German bond fell by as much as 31 basis points to 4.11 percent today, the biggest decline in yields in 10 years.

`Risky' Investment

Investors who are buying shorter-dated notes for safety should be aware that ``chasing government bonds at these levels could be risky,'' Ostwald said.

European retail sales fell an annual 1.8 percent, matching the decline in July, the European Union's statistics office in Luxembourg said today. France's economy slipped into a recession in the third quarter for the first time in more than 15 years, economists at Insee, the national statistics office, said today.

Europe's Dow Jones Stoxx 600 Index rose 2.6 percent on speculation the House of Representatives will back the amended rescue plan after it was amended and approved by the Senate.

UBS AG, the European lender hardest hit by the credit crisis, said it will cut 2,000 more jobs from its investment bank unit.

`Exceptional Uncertainty'

The cost of borrowing in dollars for three months in London rose to the highest level since January, the British Bankers' Association said. The London interbank offered rate, or Libor, that banks charge each other for such loans climbed 12 basis points to 4.33 percent, BBA data showed today.

``There is an exceptionally high level of uncertainty'' stemming from the credit-market turmoil, and as a result, ``upside risks to price stability have diminished somewhat, but have not disappeared,'' Trichet told reporters in Frankfurt yesterday.

Two-year notes yielded 61 basis points less than 10-year bunds today on bets the economic slowdown will force policy makers to cut rates by year-end. The shorter-dated securities yielded 22 basis points more than bunds as recently as June 6.

``For us, like the market, Trichet's discourse laid the ground for a rate cut in November,'' Ciaran O'Hagan, a fixed- income strategist in Paris at Societe Generale SA, wrote in a client note. ``The market is unlikely to price much less than a 25 basis-point cut over coming weeks.''

Futures Bets

Investors increased wagers on rate cuts by the ECB and lowered their inflation expectations, with the implied yield on the December Euribor futures contract dropping 7 basis points to 4.76 percent, the lowest level since May.

The difference in yield between the five-year French inflation-protected note and its regular counterpart fell to 1.8 percentage points, near the lowest in at least 2 1/2 years, from 2.17 percentage points a week ago. The so-called breakeven rate was at a record 2.83 percentage points on July 3.

European bonds soared this week, with two-year yields yesterday reaching the lowest level since March 20, as governments bailed out as many as five financial institutions in the U.S. and Europe battered by the freeze in short-term credit. Banks are reluctant to lend on concern more of their peers will collapse after New York-based Lehman Brothers Holdings Inc. filed for bankruptcy two weeks ago.

Outperform Treasuries

European bonds outperformed U.S. Treasuries in the past three months, handing investors a 5 percent return, compared with 3.3 percent for their U.S. counterparts, according to Merrill Lynch & Co.'s EMU Direct and Treasury Master indexes.

The yield advantage of the two-year German government note over equivalent-maturity U.S. securities decreased 12 basis points to 156 basis points. The spread has narrowed from 226 basis points on June 6, which was the most this year.

Belgium's government will sell 5.7 billion euros of short- dated securities to fund its contribution to the rescue of Fortis and Dexia SA. The government's participation in the bailout will push the gross financing requirement this year to 39.9 billion euros, Belgium's Debt Agency said today.

To contact the reporter on this story: Lukanyo Mnyanda in London at lmnyanda@bloomberg.net